Volatility is back
The recent sharp correction of equity markets and the increase in yields which have materialized since the start of the year have created a turbulent phase, interrupting the “Garden of Eden” kind of setting which investors were getting used to. The VIX index spiked above 37, a level not seen since 2015. All this came after a very rewarding year for investors.
In 2017, the S&P index recorded a positive performance in almost every month of last year in a context of exceptionally low volatility. Eighteen out of the 20 lowest levels of the VIX of the last 20 years were printed in 2017. Market complacency led many investors to ignore the extreme valuations alerts and to enter overcrowded trades. After the sharp correction in the equity market and the realignment to higher inflation expectations for yields, the main investor question is: Are the unique conditions which have supported the long phase of asset inflation set to continue?
We expect the synchronised global growth scenario to hold, even accelerate, with some good news from capex and a rebound in global trade, but Central Banks (CB) outlooks are becoming more challenging. CB have played a powerful role in the “Goldilocks narrative”, and a potential withdrawal of the ECB or the BoJ from their massive stimulus programmes – no longer consistent with strong economic conditions – could trigger other episodes of turbulence in the market. In this respect, volatility was clearly absent in 2017 and market complacency partly influenced investor judgement. While valuing the structural improvements of economies, the strong earnings growth visible in many areas and the very significant progress of EM in terms of rebalancing, we observe that markets’ attitudes were (and are) often asymmetric, favouring friendly news and disregarding risks. Geopolitical turmoil was largely ignored. Concerns about medium-term imbalances, such as the continuous increase of aggregate debt or the misallocation of capital caused by artificially low interest rates, are currently being ignored and likely won’t be addressed for some time. A mix of loose financial conditions, global growth and complacency have led markets to high or even extreme valuations (in some areas).
Together with the very gradual but established process of monetary tightening, this creates less positive conditions for financial markets in the second part of the year. Investors are likely to face more challenging conditions, in which economic outlooks will still be favourable, but some areas of expensive valuations and exuberance will leave the market more vulnerable to further corrections (i.e., highly indebted corporates that could be negatively affected when interest rates rise). Risk management and effective diversification would become priorities in this situation. We could potentially see sharp spikes in interest rates and a selloff in equities to occur in a market with depressed volatility and high complacency.
Asset class correlations could change, with a significant negative effect impact, in times of turbulence. So, it is crucial to pursue investment strategies that would preserve investor capital in any circumstance, and to set these now, when financial conditions are benign and it is easier to maintain portfolio liquidity. For fixed income, this means focusing on flexible duration strategies and credit risk, looking for the critical risk/return balance, and increasing sources of diversification. For equities, the focus should be on the areas where positive future developments are less discounted (EU, Japan) or could benefit from an extension of the reflation story (US).
For both equity and fixed income, but also for multi-asset, as the cycle becomes mature, it will be important to extract returns from relative value stories more than from directional risk on /risk-off exposure. Balancing short-term and tactical strategies with long-term investments (even accounting for an illiquidity premium) should support the creation of more resilient portfolios.